Limits of Arbitrage

Many value investors acknowledge that there are many other smart traders, but believe these other traders somehow don’t understand value investing. It appears, a lot of value investors are hugely overconfident when it comes to their special insight, i.e., that value investing works and others just don’t get it. Yet, there is overwhelming evidence that value investing does work and continuous to work even after a lot has been written about it. So, why does the value premium persist? Fortunately, there are better explanations than ignorance. Behavioral finance tries to explain the outperformance of value strategies by differentiating between noise traders, arbitrageurs, and their clients. On the one hand, there has to be someone who, probably due to some bias, e.g. extending the recent negative earnings trend too far into the future and thereby ignoring regression to the mean, sells an asset at a price below fundamental value (the noise trader). On the other hand, there has to be some reason why professional traders with vast resources do not arbitrage this price/value gap away immediately. This is crucial but often ignored. Shleifer and Vishny (1997) explore a possible reason why mispricings may occur even if specialized arbitrageurs are knowledgeable and rational.[1] They do this by assuming that the arbitrageur and the owner of the invested money are two separate entities. According to their model, the arbitrageur’s clients update their prior beliefs about the arbitrageur’s competence by incorporating the recent performance of investments in their assessment. Understanding the limits of arbitrage can help us separating undervalued assets from superficially cheap but not actually underpriced assets.

The key insights are:

In academia, arbitrage is typically defined as riskless without the need of capital. In practice, however, it does require capital (usually part of it from outside investors) and is associated with several forms of risk.

Arbitrage is typically performed by specialized traders who are not well diversified.

Especially in value situations, assets can further decline in price in the short run, even if it is a good bet long-term.

Clients do not have perfect knowledge of the arbitrageur’s competence. It can thus be a rational choice to withdraw capital from an underperforming manager. This forces the manager to sell off assets, even though the expected return actually increased after the price drop.

An agency problem breaks down the link between greater mispricing and higher expected return from the client’s perspective.

This can result in irrational prices while the arbitrageurs and their clients themselves act rationally.

In which situations is arbitrage most limited then?

First and foremost: Small Size. The absolute dollar amount that can be earned arbitraging in extremely small situations is just too small to make the return on invested resources attractive for professional fund managers. This just leaves individual investors. But in the smallest situations, even these investors have to be either inexperienced or so far unsuccessful, or they would have gathered enough capital to make it uneconomical for them as well. Sounds like weak competition to me!

For professional fund managers, very volatile markets increase the risk of looking incompetent in the short term. Therefore, all else equal, we should expect less arbitrage in volatile markets.

The risk of further price declines is greater in situations that take a longer time to play out and are unpredictable. Hence, we should see more arbitrage in strategies that play out (at least partially) before clients can withdraw capital and less when there may be many months or even years of underperformance before the manager is eventually proven right.

Building on that point, this effect should be more severe for assets where there is clearly something wrong — the typical deep value stock. On average, betting on value stocks can be a good idea, but you can look extremely incompetent on any given investment. Hindsight bias compounds this issue. Value situations that do not play out look like stupid investments in hindsight. It might thus be a good idea, as an individual investor, to explicitly focus on situations where one can look extremely incompetent or neglecting on any individual investment to an ignorant outsider (incompetent or self-serving corporate insiders, industry downturn, loss of major customer, negative earnings trend, regulatory issues, etc.)

Of course, identifying areas where mispricings are likely is itself not a viable investment approach. Assets can be undervalued as well as overvalued. But combined with a value ranking, e.g. EV/EBIT, searching in less efficient markets can reduce the risk of buying statistically cheap stocks which prices are actually justified. This is a completely different approach of trying to exclude value traps than the typical qualitative assessment.